Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. We’ll look at Associated British Foods plc’s (LON:ABF) P/E ratio and reflect on what it tells us about the company’s share price. Associated British Foods has a P/E ratio of 23.96, based on the last twelve months. That is equivalent to an earnings yield of about 4.2%.
How Do You Calculate Associated British Foods’s P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Associated British Foods:
P/E of 23.96 = £26.62 ÷ £1.11 (Based on the trailing twelve months to September 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each £1 the company has earned over the last year. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
Does Associated British Foods Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that Associated British Foods has a higher P/E than the average (16.5) P/E for companies in the food industry.
Its relatively high P/E ratio indicates that Associated British Foods shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Associated British Foods shrunk earnings per share by 13% over the last year. But over the longer term (5 years) earnings per share have increased by 2.9%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The ‘Price’ in P/E reflects the market capitalization of the company. So it won’t reflect the advantage of cash, or disadvantage of debt. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
How Does Associated British Foods’s Debt Impact Its P/E Ratio?
Since Associated British Foods holds net cash of UK£950m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Associated British Foods’s P/E Ratio
Associated British Foods trades on a P/E ratio of 24.0, which is above its market average of 18.3. The recent drop in earnings per share would make some investors cautious, but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will!
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
Of course you might be able to find a better stock than Associated British Foods. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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